Fed Rate Hike: What Does It Mean?
Federal funds rate raised
On Wednesday, December 16, 2015, the Federal Reserve raised the federal funds target rate, the interest rate at which banks lend funds to each other (typically overnight) within the Federal Reserve System. Since December 2008, the Fed had kept the range at a previously unheard-of level of 0% to 0.25% to help ensure that credit would be available to promote economic recovery. With this change, the target range will be 0.25% to 0.50%. In announcing its decision, the Federal Open Market Committee explained that the economy has been expanding moderately and is expected to continue expanding at a similar pace. The Committee also stated that it expects labor market conditions will continue to strengthen and that inflation will rise to 2% over the medium term.
Since the federal funds rate is a short-term rate that banks pay to borrow money, it is a factor in how banks set their own rates. The federal funds rate also serves as a benchmark for many short-term rates, such as saving accounts, money market accounts, and short-term bonds.
Additional increases ahead?
According to the Committee, “[i]n determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.” (Source: Federal Reserve Press Release, December 16, 2015) The Committee stated that it expects economic conditions will result in only gradual increases to the federal funds rate. This means that it’s possible there will be additional small increases in the coming year, though it is unlikely there will be a large jump.
What does it mean for you?
First, it’s important to put things in perspective. Despite all the headlines, by any measure this is a small increase. And the increase itself is a reflection of an improving economy.
The federal funds rate does have an effect on interest rates in general, though. So, here are some things to consider:
- Bond prices tend to fall when interest rates rise. Longer-term bonds may feel a greater impact than those with shorter maturities. That’s because when interest rates are rising, bond investors may be reluctant to tie up their money for longer periods if they anticipate higher yields in the future; and the longer a bond’s term, the greater the risk that its yield may eventually be superceded by that of newer bonds. Of course, while bonds redeemed prior to maturity may be worth more or less than their original value, if you hold a bond to maturity, you would suffer no loss of principal unless the issuer defaults.
- Rising interest rates can affect equities as well, though not as directly as bonds. For example, companies that have borrowed heavily in recent years to take advantage of low rates could see borrowing costs increase, which could affect their bottom lines. And if interest rates continue to rise to a level that’s more competitive with the return on stocks, investor demand for equities could fall.
- Rising interest rates could eventually help savers who have money in cash alternatives. Savings accounts, CDs, and money market funds are all likely to provide somewhat higher income. The downside, though, is that if higher rates are accompanied by inflation, these cash alternatives may not keep pace with rising prices.
- The prime rate, which commercial banks charge their best customers, is typically tied to the federal funds rate. Though actual rates can vary widely, small-business loans, adjustable-rate mortgages, home-equity lines of credit, credit cards, and new auto loans are often linked to the prime rate, which means that when the federal funds rate increases, the rates on these types of loans tend to go up as well.
- Although a number of other factors come into play, increases in the federal funds rate may also put some upward pressure on new fixed home mortgage rates.
The bottom line? Don’t overreact. But do take this opportunity to think about how rising interest rates could affect you, and consider discussing your overall situation with your financial professional.
All investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful. Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information can be found in the prospectus, which can be obtained from the fund or from your financial professional. Read it carefully before investing.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.
There is no assurance that working with a financial professional will improve investment results. However, a financial professional who focuses on your overall objectives can help you consider strategies that could have a substantial effect on your long-term financial situation.
The foregoing is provided for information purposes only. It is not intended or designed to provide legal, accounting, tax, investment or other professional advice. Such advice requires consideration of individual circumstances. Before any action is taken based upon this information, it is essential that competent, individual, professional advice be obtained. JAS Financial Services, LLC is not responsible for any modifications made to this material, or for the accuracy of information provided by other sources.
A Harvard professor of economics thinks inveseting is complicated
The article’s title, “Why Investing Is So Complicated, and How to Make It Simpler”, caught my attention. The article was in the July 11, 2015 edition of TheUpshot NY Times. Sendhil Mullainathan (the author of the article) compared investing to “taking a final exam in a class” he never attended.
Sendhil concludes his article with his realization that paralysis is the biggest cost of procrastination. The paralysis was caused by his fear of making a mistake in choosing an investment. During the time he did not act his money did not earn anything as his money was not invested.
He identified some of the reasons why investing is so difficult. One reason is the lack of sound employer-provided pension plans. Today we must take the steps to provide the comfortable retirement that we want. Savings becomes a primary activity required to meet our financial goals. I am including investing as part of savings for this purpose. Maximizing contributions to 401(k) accounts and IRAs (Traditional and/or Roth) become important. Adopting tax favored retirement plans are an important tool for the self-employed entrepreneur.
Finding quality financial advisers was another issue he identified. A study he was associated with “…examined advisers who did not charge clients directly. Their advice was ‘free,’ but under current rules, their advice only had to meet a very low standard – it only had to be ‘suitable’ in a broad sense of the word.” Mr. Mullaimathan referred to the need for a meaningful fiduciary standard. The struggle to adopt a fiduciary standard has been going on for a long time. Congress seems to have been the roadblock. I leave to your imagination why they resist holding all financial advisers to a fiduciary standard.
The discussion included the variation in funds (mutual funds and exchange traded funds). His approach was to find a broad-based indexed fund. He mentioned the Standard & Poor’s 500 and the Russell 2000 indexes. Many funds do not include the entire index. There are funds that use statistical sampling to include a desired portion of all the securities in the index. Other funds filter out some securities. A fund may use one or more factors to determine the securities to be included. Some, but not all the, factors are: how may years the firm has existed, how long the security has been listed, profitability, dividends, balance sheet and sales. There are indexes that only include specific sectors, specific regions, specific firm size, growth characteristics, social responsibility, etc. Another variation is the weight each security has within the index. Some, but not all, determine the amount of each security by: the firms total market value, by the value of a share, and equal amount of each security.
There are a lot of advantages to using index funds. Look for what is included, what is excluded and weighting the fund gives to each security included in the index. The number of funds and types of funds you should have should be determined based on your specific situation. Pay close attention to cost. One potential advantage of an indexed approach is reduced cost. Too many indexes could defeat the diversification of a portfolio. You should also look at how the index fund compares to the index. If the performance is not close to the index, then you may not get what you are looking for.
The lessons learned from “the old Enron story” still apply.
The following is from Edward Mendlowitz’s Feb. 24, 2015 Blog.
“in his book Money: Master the Game, Tony Robbins dredges up the old Enron story, which I agree with, and want to call to your attention now. Here is a brief listing copied from Tony’s book of the lauds, Enron received right up until their bankruptcy filing.
Mar 21, 2001 Merrill Lynch recommends
Mar 29, 2001 Goldman Sacks recommends
June 8, 2001 J.P. Morgan recommends
Aug 15, 2001 Bank of America recommends
Oct 4, 2001 A G Edwards recommends
Oct 24, 2001 Lehman Brothers recommends
Nov 12, 2001 Prudential recommends
Nov 21, 2001 Goldman Sacks recommends (again)
Nov 29, 2011 Credit Suisse First Boston recommends
Dec 2, 2001 Enron files Bankruptcy
Millions of Investors trusted these venerable firms and followed their recommendations. A question I had at the time was, “How much work did they do before they made their recommendations?” I could not have been too much since every recommendation was wrong. Another observation is that many of the largest mutual funds has significant positions in Enron.
Now, lets fast forward to today. Has anything changed? Were lessons learned? Are more intensive analysis being done now? I suggest that nothing has changed. Examples are in the many recommendations to buy oil stocks a few months ago before a subsequent additional 35% drop. …Next, as Robbins points out, most actively managed mutual funds do not outperform the index they are trying to beat….
The principles in the book are easy to understand, digest and act on…. I have condensed them [his seven steps] and … restate as follows:
1. Commit to regular savings program
2. Know and understand why you are investing in
3. Develop a plan and, while at it, reduce spending, keep investment costs low and shed debt
4. Allocate your assets carefully and rebalance periodically
5. Create a lifetime income plan
6. Invest like the .001%, i.e. don’t be stupid and re-look at step 2
7. Be happy by growing and giving
All good advice you can start following today.
A helpful list for investors
It seems that everyone has a list on almost every topic, especially at year-end and the start of a new year. I sometimes wonder what to do with this information. Anna Prior’s Jan. 2, 2015 New York Times article, “The 15 Numbers Every Investor Needs to Know” is an exception. It provides an approach to planning. Following is a condensed discussion of the article:
- Know what allocation of stocks, bonds and cash is appropriate for you. Among the many factors to consider are: your financial goals, the value of your current investments, your health, your age, and your ability to withstand a drop in the value of your investments.
- Take advantage of your ability to contribute to your employers’ 401(k) retirement plan, if applicable, for your situation. The 2015 maximum contribution is $18,000 for a pretax traditional 401(k) plan and after-tax Roth 401(k) plan. Those 50 or older can contribute an additional $6,000. Understand the requirements and impact of taking distributions from your retirement plans.
- Be familiar with the general valuations of stocks. This will help you gage your investment risk. Compare the average price/earnings (PE) ratio of stocks to the current PE. The S&P 500 is commonly used as a proxy for the stock market.
- Some consider bonds as a source of safety for investors. It is difficult to predict how bonds will perform in the short-term. The yield on the 10-year Treasury note will give you an indication of what the yield on bonds will be in the next 10 years or so.
- High investment costs will reduce your returns The expense ratios of your funds can be found in the fund prospectus, the website of the fund company and other media sources.
- Be aware of your adjusted gross income (AGI). This is the amount at the bottom of page one of you individual U.S income tax return. The AGI will determine if other taxes or limitations will apply to you. Examples are the 3.8% surtax on investment income, Medicare Part B & D premiums, deduction of some retirement plans, and some itemized deductions.
- Estate-tax exemption of the states are often lower than the U.S. estate exemption. This must be considered in your planing for your family, heirs and charitable entities.
- The amount of your essential and discretionary costs should be reviewed periodically. This is important for: retirement planning, insurance planning and maintaining an adequate reserve fund for the unexpected and untimely expenditures.
- Understand your health-care expenses. This is need for; insurance planning, retirement planning and maintaining an adequate reserve fund.
- Be aware of the difference between replacement cost and fair market value. The difference to rebuilding a home can vary from what the home would sell for. Replacing the contents of you home may be more than the fair market of the items.
- The difference between owning and renting a home can have a major impact on your cash flow and quality of life. The impact maybe more significant when buying a first home and when retiring.
- How long you are likely to live has a significant impact on your investment planning and cash flow planning.
- Your approach to borrowing and repaying loans impacts your cash flow planning, investment planning and retirement planning.
- Be aware of current and anticipated mortgage rates. These impact planning relating to refinancing and debt repayment (cash flow planning).
There are many moving factors in planning. An understanding of the parts and the alternatives are essential to a successful plan.
Market movements are often not based on fact.
Robert J. Shiller’s October 18th New York Times article, “When a Stock Market Theory Is Contagious” discusses the recent stock market fluctuation. In addition to being a professor of economics at Yale University, he has authored many books, writes columns, co-created the “S&P/Case-Shiller Home Price Indices” and was 1 of 3 recipients of the 2013 Nobel Prize in Economic Sciences.
The topic of the article ties into my comments about risk and volatility in my October newsletter.
“The problem is that short-term market movements are extremely hard to forecast. But we live in the present and must try to understand what’s driving the market now, even if it’s much easier to predict their behavior in the long run.” That is to say we do not know the future, but we can explain what happened in the past.
“…stock markets are driven by popular narratives, which don’t need basis in solid fact.” The article compares the narratives with the “Ebola virus: they spread by contagion.” The narratives causes investors “…to take action that propels prices…in the same direction.” That is, we do not know why the market fell but people and companies may respond by cutting spending resulting in the market falling further.
Recent stories attribute the current drop in the stock market to a “global slowdown”. The narrative can cause people and companies to spend less continuing the fall in the stock market. He concludes with the following. “The question may be whether the virus mutates into a more psychologically powerful version, one with enough narrative force to create a major bear market.”
Financial markets fluctuate
Discussions in articles, books, studies and commentaries from different sources have some common elements about investing. Investing is discussed in different contexts. Examples of the different discussions include: performance, risk, retirement, budgeting, goals and government policies.
An example is an August 15th New York Times article:”Fears of Renewed Instability as Fed Ends Stimulus”. The article reflects a conversation with Jeremy Stein, who left the Fed’s Board of Governors at the end of May to return to Harvard’s economics department.
Many investors are getting nervous because of the length of good stock and bond performance. Recent fluctuations are a reminder that markets go down as well as up. Maybe the recent gyrations are signs of impending instability.
Referring to the Federal Reserve (Fed) actions the article discusses the possible unintended consequences of the Fed policies that have guided us through the recent financial crisis. The low rates have resulted in investors reaching for yield. The consequence of reaching for higher yield is increased risk. Some investors may not realize the increased chance of losses. The result could be further strain on our economy.
The author of the article, James B. Stewart, included the following:
The Princeton economist Markus K. Brunnermeier, an expert on asset bubbles and crashes, has identified what he calls “synchronization risk,” a phenomenon in which investors ride a wave of price increases even if they realize the assets are overpriced. “It’s what economists call a lack of common knowledge,” he said. “We may all know an asset price is too high, but we don’t know the others know it, too. Timing is everything. The danger is if you move too early and the market doesn’t follow up. So everyone waits on the sidelines watching and listening,” as long as asset prices keep rising. The danger comes when they all try to get out at the same time.”
“No one wants another crash, but a garden-variety correction may be just what’s needed to avoid one in the future.”
The discussion recognizes that the market fluctuates. Frequent and/or large fluctuations indicate concern about the future direction of the markets. No one thinks they know what direction the market will go when it fluctuates. Investors are cautious when the market gyrate. They become optimistic when the market continues to rally. This is when investors become confident and make mistakes.
Economists, journalists, regulators and politicians are all poor forecasters of the future movement of the markets.
Do you know if you will owe tax as a shareholder of a company that completes an inversion?
“Inversions” are the subject of Laura Saunders August 1, 2014 article in the Wall Street Journal, “An ‘Inversion’ Deal Could Raise Your Taxes”.
An “inversion” is when a U.S. company merges into a foreign company. Some U.S. companies (e.g. AbbVie, Applied Materials, Auxilium Pharmesuticals, Chiquita Brands International, Medtronic, Mylan, Pfizer, Salix Pharmaceuticals and Walgreen) have considered or are pursuing an “inversion” to reduce U.S. income tax.
It is expected that the “inversion” will be taxable to U.S. shareholders. Technically the U.S. company is being acquired in a taxable transaction. It is unlikely that the shareholders will receive any cash.
The tax consequences will vary based on each shareholder’s specific situation.
The net investment income tax (3.8%) will apply if your adjusted gross income (AGI) exceeds $200,000 if single and $250,000 if married filing jointly.
The long term capital gains rate is 20% if your AGI exceeds $400,000 if single and $450,000 if married filing jointly; 15% if your AGI exceeds $8,950 through $400,000 if single and $17,900 if married filing jointly.
The impact of the alternative minimum tax, itemized deduction phase-out and personal exemption are some of the other factors to consider.
Taxes will not be due if the stock is held in a traditional individual retirement account (IRA), Roth IRA, 401(k), or other tax-deferred vehicles.
Taxes are only on factor to consider, not the controlling factor, in deciding if the stock of a company considering an “inversion” should be bought, sold or held.
“Inversions” will be especially unwelcome for long-term investors who were planning to hold their shares until death for estate-planning purposes. At that point, there is no capital-gains bill, so some shareholders in firms doing “inversions” will owe taxes they would never have had to pay.”
The tax could be reduced if you have any unused losses from prior years.
Selling other stock or investments that have losses is a strategy to reduce tax from the “inversion”.
Gifting the stock to someone in a lower tax bracket (e.g. young child, grandchild, retired parent or grandparent) is another stragey to reduce the tax. The timing of the gift is important.
Contributing the stock to a charity is another approach if you have held the stock for more than a year and will have a gain. The gain will not be taxed and the value of the stock may be deductible as a charitable contribution, subject to limitations. Be sure to get a timely qualified acknowledgment. Allow enough time to complete the transaction before the “inversion”.
Among the other issues to be considered are: gift/estate taxes, “kiddie tax”, and possible retroactive legislation restricting “inversions”.
This is not intended as a complete discussion of all the factors and consequences to consider. You should consult with your personal advisers to determine what if any action is appropriate for you.
Is your portfo as divesified as you think it is?
The following is taken fron an article in the July 2014 issue of Morningstar ETFInvestor. Samuel Lee was the author of the article.
“Most investors understand that they should diversify a lot. However, some hurt themselves by behaving inconsistently. They diversify a lot while implicitly behaving as if they know a lot. A big subset of this group is investors who own lots of different expensive funds. Owning one expensive fund is a high-confidence bet on the manager. Well-done studies estimate that the percentage of truly skilled mutual fund managers is in the low single digits.
It would be strange if your process for assessing mangers turns up lots and lots of skilled ones, because there aren’t many in the first place. (If you see skilled mangers everywhere, chances are your process is broken or not discriminating enough.) It would be even stranger if you bet on many of them. Doing so dooms you to getting index-like results while paying hefty fees. It makes little sense to pay 1% or more of assets on an aggregate portfolio with hundreds of positions and marketlike behavior.
An exception is if you assemble a portfolio of extremely concentrated fund mangers. Owning 10 funds with 10 stocks each put together will look like a moderately concentrated fund manager. This is a model some successful endowments, hedge funds, and mutual funds use.
Most investors should own diversified, low-cost funds. Those who believe they know something should concentrate to the extent that they’re confident in their own abilities. A big dang is that humans are overconfident; many will concentrate when they should be diversified.”
Pay special attention to the above if you think it does not apply to you!
Pipe Dreams
Samuel Lee is an ETF strategist and editor of "Morningstar ETF Investor". His message is very similar to beliefs of many well known and respected individuals such as Jack Bogle, Warren E. Buffett, Larry E. Swedroe and Carl Richards. Researches by firms such as Morningstar, Vanguard and Dalbar have come to the same conclusions.
Investing is a zero-sum activity. If the seller is wrong the buyer is right. If you prefer, if the buyer is wrong, the seller is right. Each believes their decision to buy or sell is correct. Mr. Lee believes that close to 99% who try to beat the market will fail.
Costs are a significant factor in determining who will make money and who will lose money on any transaction. Trading increases cost and reduces the returns.
Mr. Buffett recently indicated his survivors should put their money in index funds and move on. His annual letter to Berkshire shareholders included the following: … "Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting friction costs can be huge and, for investors in aggregate, devoid of benefits. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm."
Warren Buffet is the exception to the rule. He has exceptional skills and access to information and resources not available to most people. Most active mutual funds also do not outperform the market.
John Bogle compares investing to farming. Mr. Bogle compares investing to gardening in his book "Common Sense on Mutual funds. The book references "Chauncey Gardiner" (played by Peter Sellers in the movie) Jerzy Kosinki’s book "Being There". "The seasons of the garden find a parallel in the cycles of the economy and the financial markets, and we can emulate his faith that their patterns …will define their course in the future."
Investing should be based on a plan to achieve your financial goals. It is a long-term process that requires research and patience. Passive investing will improve the returns for most people. Almost everyone believes they are better than most people. The Dalbar studies for the past 25 years are based on real investor returns. Most people think they did better than their actual results.
Risk
It is important for you to understand your tolerance for risk and capacity to recover from investment losses. Financial professionals need to understand this also. It is part of the understanding needed to help develop a foundation to guide you through your life’s journey.
Risk tolerance is your capacity to withstand a loss. Your capacity to withstand a financial loss is your ability to recover from or absorb a financial loss and still be able reach your financial goals. If the probability of an investment portfolio is too low, then the person does not have the capacity to withstand the loss.
If you do not have the tolerance or capacity to withstand a loss, something else may need to be changed. It may be any combination of actions including: increasing income, lowering expenses, increasing savings, or lowering financial goals.
The reliability of your sources of income is another factor to consider. If have a good job with a strong reliable company in a growing industry, you are in a better position to withstand investment losses. However, if you are not satisfied with your employment you are not in as good of a position to withstand investment losses.
Age and health are two other factors to consider. If you are in the earlier stages of you career, you have more time and resources to recover from investment losses. The existence of health issues generally reduces the ability and flexibility to withstand losses.
Future plans to start a new business and to travel extensively are two other factors to consider. These plans may reduce your ability and flexibility to recover from investment risks.
This discussion is an introduction to an understanding of your risk tolerance and capacity. Without this understanding, your financial planning may not be achievable.
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This graph represents the effective federal funds rate from 1981 through 2014. Source: Board of Governors of the Federal Reserve System (www.federalreserve.gov), December 16, 2015